Getting started: Why startups should consult tax professionals

The School of Accountancy's Professor of Practice Donald Goldman offers a cautionary tale that illustrates the consequences of cutting corners when starting a business. In this case, saving a few dollars on legal advice in the beginning cost $3 million in the end.

By Donald Goldman  |  Professor of Practice

Amanda and Jackson worked for a large company, Amanda as an engineer and Jackson as a sales manager. Several customers asked Jackson if the company had a product to address a specific need. It didn’t. He talked to Amanda. She thought she could design a product to meet the need, but the company said the market was too small and wasn’t interested.

Amanda and Jackson began to investigate forming their own company to develop and market a product to address the customers’ need. They took almost all the right steps: They did market research, developed a business plan, explored sources of financing, etc. It looked promising, so they took the leap. They quit their jobs and formed a corporation, each owning 50 percent of the stock.

They were successful — in fact, they were so successful that four years later their former employer offered them $10 million for the assets of their business. They agreed the price was fair and decided to sell, thinking that each of them would end up with about $4 million after tax. Unfortunately, Amanda and Jackson had made a critical mistake. To save money, they hadn’t consulted a tax professional before forming their business.

The big, successful companies they knew about were all corporations, so they figured they should operate as a corporation as well. Besides, they knew that the top federal income tax rate on corporations is less than the top rate for individuals. However, they failed to recognize two significant downsides to operating as a corporation: lack of a beneficial income tax rate for capital gains and double taxation.

If they had operated the business as a pass-through entity such as a partnership, LLC or S corporation (a corporation that made an election with the IRS to have its profits taxed to its shareholders rather than the corporation), they would have ended up with $8 million to split after paying $2 million in taxes at capital gains rates. However, because their business was taxed as a corporation, the corporation would pay about $3.5 million in tax on the sale of its assets. If that weren’t bad enough, Amanda and Jackson would have to pay an additional $1.5 million in tax to get the remaining funds out of the corporation.

Instead of a total tax of $2 million, leaving them with $8 million to share, there would be total tax of $5 million, leaving them with $5 million to share. The decision to save a few dollars on tax advice when starting the business would now cost them $3 million! In fact, that additional tax burden might even make them reconsider whether or not to sell the business. The moral of the story: When starting a business, make sure to consider the income tax consequences of the form of your business entity. Spending a few dollars now can save a lot in the future.

W. P. Carey professors are the authors of the Getting Started column, a weekly feature in The Arizona Republic targeted at entrepreneurs and small business owners. Distilled from curriculum and research, the columns provide tips and knowledge that business professionals can put into action immediately. After the Republic publishes, we re-post on the Research and Ideas homepage.

First published in The Arizona Republic, July 21, 2015.